Small and medium sized enterprises (SME’s) are businesses with turnover less than $50m1 . They are a substantial portion of the economy, employing almost 70% of the Australian workforce2 and providing a business lending market of $433bn across 644,000 businesses3 . This is a significant opportunity for the big 4 banking incumbents, challenger banks such as Judo (listed in 2021), and the increasing smorgasbord of financial technology enabled non-bank lenders. The funding of these non-bank lenders in turn presents an important new opportunity for private credit funds such as ours to seek a stable income return for clients.
In this note we delve into these trends a little more deeply and highlight why we find one particular SME lending product, insured receivables funding, particularly appealing as private credit investors.
Recent trends in SME borrowing needs are illustrated in the RBA chart below. It can be seen that their financing requirements are driven by property, working capital and plant and equipment and interestingly that overall, their demand for finance has been robust through the pandemic.
Why are non-bank lenders increasingly displacing banks as lenders to SME’s?
Well over a quarter of all SME’s (28.7%) plan to use a non-bank lender to fund new business investment4 . While banks are still the largest lenders to SME’s, the share of lending to SME’s provided by non-bank lenders has increased dramatically and will continue to do so. Why is this?
1. Access to finance and the requirement for security over residential property – for many years small businesses have reported that they find it difficult to access finance on terms that suit their needs. Small businesses tend to face a number of difficulties accessing finance associated with their smaller scale, less diversified nature and lack of collateral. They are therefore often required to provide collateral such as personal guarantees secured by residential property to receive finance from banks5 .
There are several reasons why an SME may find the provision of property as security to be challenging, including:
- a young entrepreneur may not own a home, or hold much equity in it, even if they do;
- a business owner with an existing household mortgage may not have enough equity headroom to support a business loan;
- general reluctance among business owners to borrow against their family home; and
- using a residential home as business security concentrates the risk the business owner faces6
Non-bank lenders are addressing this issue by providing financing solutions to SME’s that do not require security over directors’ residential property. This is an example how, in many cases, non-banks are now able to offer SME clients a better risk / reward package than the incumbent banks. In part this is because banks need to operate at scale and provide a customised product whereas non-bank lenders, enormously enabled by new financial technology and with a less onerous cost base, are able to provide a more bespoke offering with customised pricing to SME’s. Also, in many cases, capital and regulatory requirements have resulted in bank pullback from certain sectors of the SME market.
This is obviously compelling for borrowers but does raise the question as to whether non-bank lenders may be taking on excessive levels of risk in their pursuit of a new market. Private credit funds as funders to non-bank lenders need to address this risk by considering whether the appropriate underwriting guidelines are in place and are being followed.
The RBA chart below shows a recent improvement in small business perceptions of access to finance (albeit slightly Covid interrupted), in our view reflecting the impact non-bank lenders are having on SME lending.
The chart below from the Judo Bank prospectus is also instructive on why SME borrowers are turning to non-bank lenders.
2. Non-banks have also been able to capitalise on two emerging separate but related themes to compete with the incumbent banks in SME lending.
Firstly, the democratisation of financial technology via cloud-based systems provides an almost level playing field from a technology perspective – perhaps even a playing field that favours new entrants not blinkered by legacy systems. For example, a new non-bank can easily and cheaply use Xero to seamlessly have sight of activity on its borrowers’ receivables while scrutinising their bank accounts with bankstatements.com.au. Also, borrower due diligence is facilitated by information now being much more freely available to lenders as a result of the open banking initiatives.
Secondly non-banks have been able to access cost effective term funding from the private credit market. They have done this by utilising securitisation structures which accommodate funding tranches of different seniority and pricing depending on the risk appetite of the private credit funder. Private credit funds in turn have relished the deployment opportunity that well-structured, diversified pools of receivables provide. Institutional and private investors have also increased portfolio allocations to private credit in pursuit of the potential attractive yield the asset class offers when compared to the minimal returns from traditional fixed income in the low interest rate environment that has been experienced for a while now. This investor demand has provided funding capacity for private credit funds seeking appropriate opportunities with non-bank lenders. The result is a virtuous circle between private credit funders and non-bank lenders and a private credit market that has now come of age with an estimated corporate private credit market of $109bn7 .
How did Covid affect SME lending?
SME’s of course were, and are, in many cases, significantly adversely affected by the economic consequences of the actions to combat Covid 19. Their significance to the economy is reflected by the numerous forms of government support for SME’s during this time;for example by the ATO and via the Coronavirus SME guarantee schemes phase 1 and 2 and the new SME recovery loan scheme.
Also particularly interesting was the support provided by government to the non-bank lenders during this time via the $15bn Structured Finance Support Fund, which was reflective of the importance attached by government to keeping non-bank lenders open as a key source of finance for SME’s and other borrowers during the Covid tough times. This also facilitated non-bank lenders being able to emulate the banks in offering hardship loan deferrals to their SME clients, albeit on a more selective basis than the banks. In mid-2020, a peak of around 13 per cent of all SME borrowers had a loan deferral arrangement in place and more than 225,000 business loans were deferred, although this share had declined to around 1 per cent by early 20218 .
Largely as a result of these extensive support mechanisms, SME’s in Australia did not experience significantly increased default rates as result of Covid and as a consequence private credit funds funding non-bank lenders to SME’s experienced robust returns during this period.
The experience of SME’s during Covid is captured by the confidence dip and recovery shown in the chart below.
The stability of the demand for funding by SME’s is illustrated by the steady lending volumes to small and medium businesses through the pandemic as shown by the RBA charts below.
Why do we find it attractive to lend to non-bank lenders funding insured receivables of SME’s?
There are many non-bank lenders to SME’s – in fact, more almost every day. Some provide general purpose facilities (e.g. lenders such as Shift) while others focus on specific asset classes – for example, real estate (e.g. Think Tank), equipment (e.g. FlexiCommercial) or trade receivables (e.g. Scotpac). There are also the new neo banks, some of which are focusing on servicing SME ‘s (e.g. Judo and Avenue). We’ve noted above that these non-bank lenders are competing with the banks with lending
products more attractive to the borrowers and so we need to ensure that as a private credit fund investing into their receivables books there are appropriate underwriting guidelines are in place and are being followed. The higher default probabilities one can expect from SME lending compared to other forms of lending (see below) also indicate that caution and careful selection of the right non-bank lender with the appropriate risk and business model is essential for private credit investors.
Our selection process is to focus on funding opportunities with non-bank lenders where (i) we believe there is a structural reason why the underlying borrower pool will perform well (i.e. have a low default rate) and (ii) the management team has an extensive track record.
We recently provided funding to Tradeplus24, a non-bank lender providing loan facilities to Australian SME’s secured by all their borrowers’ underlying trade receivables, and they meet our selection criteria as follows:
- The structural reason why we believe this SME loan portfolio will perform well is that, amongst their other underwriting guidelines, Tradeplus24 obtain credit insurance from a AA rated insurer on the receivables they have security over, with facility sizes limited to 80% of the insured limits. Typically, they also obtain directors guarantees. So Tradeplus24’s underwriting guidelines ensure a strong package of risk mitigation, further enhanced by the first loss risk they assumed as part of the financing we provide The way we think about is that the diversity of the underlying receivables, enhanced by the credit insurance, and considered with the return on the loan book, provides in this case a risk/reward package that validly avoids the need for the directors of the underlying borrower’s to provide residential security for their guarantees.
- The management team and shareholders have extensive experience in SME lending, both in Australia and Europe experience. On a weekly basis, they thoroughly review their borrowers receivables books using technology platforms to do so.
Tradeplus 24 is therefore, in our view, an attractive example of a niche non-bank lender providing, what we believe is, strong risk-adjusted returns to private credit investors seeking to benefit from the opportunities from SME lending via non-bank lenders.